|Figure 1 highlights the volatility index (VIX) daily chart, showcasing its sharp decline from the peak made in early November 2009. The Dow Jones Industrial Average ($INDU) charge to a 15-month high has made the VIX susceptible and vulnerable, causing it to drift down to a 19-month low in early January. In doing so, the VIX tagged the lower boundary of a very large bullish falling wedge chart pattern and formed a hollow red candlestick. Hollow red candlesticks usually accompany reversals, but that isn't always set in stone. |
When a red hollow candle appears, it usually starts off with a wide gap lower that appears on a price chart at the opening of a session. But through the course of the session, prices manage to recover and close above that opening price while also closing lower than the value of the prior day's close. This price action causes a security or index to drop, followed by a rubber band rally that causes prices to snap back up. It is this violent price movement that creates the hollow red candlestick.
|FIGURE 1: $VIX, DAILY. The breakout on the VIX (highlighted in yellow) resulted in a trilogy of bullish events to occur. It triggered a confirming close of the bullish P-p-P histogram pattern, marking a close above the 50-day EMA, and a breakout of a bullish falling wedge chart pattern.|
|Graphic provided by: StockCharts.com.|
|Once the hollow red candlestick appeared, the VIX gained traction by bouncing off the lower trendline of the falling wedge pattern in a knee-jerk reaction, causing technical indicators to turn favorable (Figure 1). The indicators turned bullish under the cloak of darkness while euphoria and irrational exuberance blinded investors into a false sense of complacency, who continued to snatch up overextended and overpriced stocks. The spontaneous uprising of the VIX was largely due to a change in momentum, putting the finishing touches on several bullish divergences in the daily time frame. |
On January 12, 2010, the moving average convergence/divergence (MACD) histogram (12, 26, 9) completed a triple bullish divergence as it put in a series of successively higher trough lows. The third trough on the histogram was more shallow than the prior two lows as a bullish P-p-P pattern appeared. Once the histogram ticked up from its shallow third bottom, it began a chain reaction of bullish events that altered the VIX from its previous bearish collision course.
|The P-p-P terminology is a code that refers to the bullish arrangement of the vertical histogram bars, signaling a bullish shift in momentum. The p-P in the pattern occurs when the oscillator is in negative territory and has an uptick that changes the slope of the histogram from down to up. The P-p-P signal is validated once the VIX closes above the highest high of the day in which the pattern appears. A move above the 50-day exponential moving average (EMA) finalizes the pattern, giving it the green light to be acted upon. Ironically, the bullish falling wedge chart pattern broke out the day that the bullish P-p-P got a confirming close and surged above the 50-day EMA, giving the signal to short the stock market using investment vehicles such as exchange traded funds (ETFs), options, or futures. The elongated bar that appeared at the breakout (highlighted in yellow in Figure 1) also shows tremendous strength. The ability of the bar to close at the highs of the session is a very powerful sign that the reversal is legitimate.|
|Note the height of the histogram bar the day that prices broke out and closed above the 50-day EMA. The histogram bar for that session moved above the centerline, and it is much taller than the previous peaks that formed in late November and December. The stature of histogram hints that the breakout is much stronger than the smaller histogram towers that superseded it, driving the VIX lower. Tall histograms that form above the centerline show that the VIX is bullish and that the index is likely to continue to move higher. Since the VIX is a contrarian indicator, that implies there is a certain amount of complacency in the stock market, presenting a golden opportunity for short-sellers.|
|The stochastic (14, 3, 3), is in agreement with the histogram. During the price breakout, the stochastic woke up after spending several weeks underneath the median line of 50, snapping to attention as it jumped back up to 50. A strong pop above that level would greatly increase short term momentum. The relative strength index (RSI)(14) also cleared 50 after completing a bullish divergence. The histogram's move above the centerline caused the MACD line to cross above its signal line, producing a bullish signal. This came after the MACD successfully tested its prior two lows, completing what is known as a bullish class C divergence (where prices fall to a new low while the indicator makes an equivalent bottom). The VIX's histogram gave traders a helping hand as it hinted to a potential reversal in the stock market. |
Click here for more information about our publications!